Five charts that matter for investors

Banks’ liquidity

In the week between 15 March and 22 March, US banks borrowed some $340 billion from the US Federal Reserve’s discount window (see chart).

Although this is below the record established during the global financial crisis ($440 billion), it is higher than that seen during the COVID-19 pandemic in 2020 ($130 billion).

The discount window, which can help to alleviate liquidity strains at a depository institution, and in the banking system as a whole, is rarely used outside of periods of significant stress.

To put things into perspective, and although these are not directly related, $340 billion is roughly equivalent to half of the liquidity that the Fed has drained from the system through so-called quantitative tightening.

It’s hard to gauge if banks decided to use the discount window as a precautionary measure or if the need was real. That said, the system, and its fail-safes, appear to be working.

Rate cuts back in vogue

Last month, 5 charts that matter for investors highlighted the significant repricing in US interest rate expectations, with markets going from pricing in 50 basis points of US interest-rate cuts in 2023 at the beginning of this year, to anticipating no more cuts.

Fast forward to today and, following the recent turmoil in the banking sector, the market has done a full 180-degree turn and now expects rates to finish 2023 lower than was the case at the beginning of the year.

Translating this into numbers, the market pricing of December 2023 fed funds rates changed from 4.55% on 1 January, to 5.55% at the beginning of March, and was back down to 4.22% as of the end of the first quarter. Similarly, the peak in interest rates, which was not so long ago seen approaching 6%, is now just below 5%. 

Markets often overreact, both on the upside and the downside. As such, the truth may well be somewhere in the middle of the above range. One thing is clear, central banks seem unlikely to abandon their fight against inflation, unless they are absolutely forced to.

Eight sigma bond-yield explosion

In the three days to 13 March, the yield on US 2-year government bonds plunged by 90 basis points, to 3.97%, in the biggest three-day move seen since 1987. 

Bond yields aren’t supposed to move that much so rapidly. In fact, this marked an eight-sigma event, or eight times the usual standard deviation expected for a three-day period. In plain English, such an event should only happen once in 4.4 trillion years (if one were to assume a normal distribution).

When unexpected ‘earthquakes’ like the above take place, many people will probably be caught off guard. This is particularly true in the financial system, where investors take risk based on probabilities.  

As such, more headlines are likely to follow of some funds posting huge losses. Thankfully, a sharp move in rates is typically less painful when it is on the downside, except for those who were long rates and short Treasuries.

Three isn’t much

The failures of Silicon Valley Bank (SVB), Signature Bank and Silvergate within a few days of each other in March created significant volatility and anxiety in financial markets. 

SVB’s bankruptcy, in particular, was reported to be the second largest US bank collapse after that of Washington Mutual in 2008.

While sensational, these headlines miss the bigger picture. First, US bank failures are a common occurrence. In fact, there have been more than 2,000 of them since 1980 (see chart). Second, although SVB is among the largest bank collapses, when measured by assets, one has to put things in a broader context. 

For example, in 1984, Continental Illinois National Bank and Trust (CINB) went under. At that time, the bank had around $40 billion in assets. While it doesn’t sound much, when adjusted for inflation, that represents around $105 billion in today’s money. 

More importantly, back in 1984, the bank’s assets accounted for around 2% of what was then a $2 trillion US pool of commercial bank assets. From that perspective, SVB’s $209 billion asset base represents less than 1% of today’s total bank’s assets ($24 trillion). In other words, SVB’s failure isn’t as meaningful as one might think just by reading the headlines.

Diversification is the answer

The recent turmoil in financial markets also serves as a stark reminder that the macro and micro economic landscapes often throw curveballs. Just like very few saw the pandemic coming, “SVB” or “banking crisis” were not on investment analysts’ bingo card for 2023.

These unknown unknowns are, by definition, impossible to anticipate and therefore impossible to hedge. One solution available to investors is appropriate diversification. By building portfolios made of assets with limited correlations to each other, investors can hope that risks will balance out over time.

This approach didn’t work in 2022, as all major asset classes posted negative real returns with the exception of commodities. Encouragingly, though, it appears that correlations for stocks and bonds have returned to more normal levels, allowing fixed income to provide some relief when equity markets struggle.

In fact, the equity-bond correlation is back in negative territory (see chart). This means that investors are once again being rewarded, from a risk management perspective, for holding a combination of stocks and bonds.